NEW YORK--(BUSINESS WIRE)--Having regulated CEO pay in firms that have received bailout money, the
Obama administration is now in serious discussions about overhauling
compensation practices across the entire financial services industry. A
working paper by Alex Edmans, Assistant Professor of Finance at the
Wharton School of the University of Pennsylvania, and Xavier Gabaix,
Associate Professor of Finance at NYU Stern, coauthored with Tomasz
Sadzik of NYU and Yuliy Sannikov of Princeton, proposes a solution to
executive compensation that will address a number of problems that led
to the current crisis. The paper is titled “Dynamic Incentive Accounts”
and is publicly available at http://ssrn.com/abstract=1361797.

There are two main problems with existing schemes: they are typically
short-term focused and they fail to keep pace with a firm’s changing
conditions. For example, if a firm’s stock plummets, options are close
to worthless and have little incentive effect.

The authors’ proposed solution aims to solve both of these issues. Their
proposal involves creating “dynamic incentive accounts” to ensure that
top management has a stake in the long-term success of the firm at all
times. “Dynamic incentive accounts” would:

Escrow the manager’s compensation in an “incentive account.” A given
fraction of the account is invested in company stock with the
remainder in cash.

Rebalance the account each month to ensure that the fraction in stock
remains above the minimum level (e.g., if the stock price falls, cash
in the account is exchanged for stock).

Pay out only a fraction of the account each month to the manager. The
account continues to vest gradually, even when the manager leaves the
firm.

Since the manager is “reloaded” with new shares after the stock falls,
his incentives remain strong. Importantly, unlike the current practice
of repricing options that have become worthless, this reloading is not
for free – the additional shares are paid for by reducing the cash in
the account. The authors explain: “Compensation schemes should tie a
manager to long-term performance, and provide strong incentives to
improve shareholder value in both good and bad times.”